S&P500 vs Inflation vs PE Ratio over 97 years

The above chart shows the 10 year performance of the S&P500 (blue bars) versus the 10 year average annual inflation (red bars) versus the Shiller PE Ratio at the start of each decade (green bars). There are several notable observations...

• The worst performance was during the 1930s when the US experienced a deflationary environment and PE ratio started very high
• The second worse performance occurred 2000-2009 when PE Ratios started through the roof (> 40) and contracted
  
• Other poor performances typically related to high inflation (1913-1919; 1970-1979) and/or PE ratio contraction (1940-1949)
  

So what do we start 2010-2019 with? A very high Shiller PE Ratio (~20.1), third highest to the start of the Great Depression and Tech Wreck/GFC decades. And, an outlook for inflation that is relatively low due to the very high unemployment that is expected to stay around for some time. The US economy has just seen an economic bounce largely on the back of inventories that are being built back up but this is not a sustainable growth driver and certainly from a sharemarket perspective not a justification for a high PE.

Whislt the US Economy recivers for decent sharemarket returns there needs to be some stronger growth drivers and what these drivers will be is a little unclear.

Fees in Perspective

From 1 November 1980 to 31 October 2009, a total of 29 years, an investment in bank bills would have yielded a total return of 1,257% which is an annual return of 9.41%...many banks provide this type of return for their customers and as we have found out in the last year or so, the Australian government is happy to protect your deposits when times are tough so the risk is very low and bank bill type returns are achievable for all of us.

Compare this to the return of the All Ordinaries Index....which is the best proxy of the broader market as it encapsulates on average around 500 of the top Australian companies...which returned 1,996%...better than bank bills...however...the annualised return is only 11.06%. This annual return represents a risk premium of only 1.65%pa.

For the average punter, access to managed funds is typically done via master trusts or wrap platforms, and guess what....their total annual product fees (which include administration, fund manager, and advice fees) are typically around 1.9%pa for an investment in an Australian Shares fund. Therefore, if you made an investment into the Australian sharemarket at the start of 1980, (which opened with around a 50% first 12 months return), you would have underperformed bank bills by paying the fees that current platforms charge adn most importantly with more risk!

No wonder the Cooper review and government will insist on fees being less than 1%pa.

State of the US Economy

For a fascinating outlook for the US Economy and property sectors, Federal Reserve of San Francisco's Janet Yellen's 10 November speech is a must read. Access it here.

Relating the Risks of Bonds to Recent Times

If you are interested in an educational article on the main risks a bond investor faces and how those risks have played out over the past year or two, please visit this link.

Economic Growth does not mean High Equity Returns

One of the more frequent queries I receive is from planners who want to invest their client's funds into high economic growth countries of India, China, and emerging markets. My response is fairly standard in that I wonder why they believe that would provide their clients and the response is typically along the lines of "their growth potential is greater than the rest of the world".

Last week, one of my favourite bloggers, Buttonwood (The Economist), provided commentary on this phenomenon, titled "The Growth Illusion". I know I'm doubling up and perhaps you can read it yourself but in essence, "the faster an economy grows does not mean the faster corporate profits grow and therefore the investor receives higher returns". A study performed performed by Dimson, Marsh and Staunton (they're a few academics involved in the production of Credit Suisse's Global Investment Returns Yearbook this year), showed that there was in fact a "negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting"...so no go there.

A second study showed that the better returns from 1990 to 2005 did not come from the highest growth economies. And a third study showed "no statistical link between one year GDP growth rate and the next year's investment returns".

Another study by Paul Marson of Lombard Odier, showed there is no correlation between GDP Growth and Stockmarket returns of Emerging Markets.

The most likely reasons for all of this rests with a few reasons stated in the Buttonwood blog...

• the potential is already recognised and factored into prices so that they are bid up to very high levels
• the stock market does not represent a country's economy and vice versa
• "growth is siphoned off by insiders at the risk of shareholders"

The best recent example I can think of is China. It may have had one of the best growth rates in 2008 but the sharemarket still crashed by 70%. With all of this good news flowing through for the month of August China's stockmarket was still down 20% (albeit up by 70% beforehand). Maybe investing in a growth economy will produce the good or maybe it won't, but as the first point above alludes to...everyone knows this so why wouldn't it already be priced in?

Bond Fund Correlations

The above chart shows the 6 month daily correlation between Hedged Global Shares and four Australian bond funds...

• Tyndall Australian Bond
• UBS International Bond
• Macquarie Diversified Fixed Interest
• Principal Global Strategic Income Fund

Each fund is different. Tyndall is invested in high grade Australian bonds, UBS International in high grade global bonds, Macquarie is 60% Australian bonds, 40% global and also takes on some investment grade credit risks, and Principal's fund invests in high yielding securities including hybrids, asset backed securities, junk bonds, as well as some conservative bonds. All global exposures are hedged to Australian dollars.

What this chart demonstrates is the increasing correlation between Principal and hedged international shares from mid 2007, the start of the credit crunch. Basically, diversification benefits did not really exist for the high yielding investment.

However for the other funds, which had conservative bonds as a high proportion, their low correlation with hedge international shares shows their diverisifcation benefits in tact.

So a simple conclusion is...whilst high yielding investment may giove you the opportunity for higher returns, don't think they will provide diversification benefits if sharemarkets tank. With a weak outlook for shares, so too is the outlook for companies to pay their debt so the price of low-grade credit can fall significantly also. A final point, which is often overlooked...bonds have limited upside...at maturity the most you will ever receive is the face value...that's it.

Yield Curve looking Good...is it too good?

As the above chart shows, the Australian government yield curve has been steepening ever since the end of last year. This yield curve is a good indicator of the future strength of the AUstralian economy. As it shows, during June of 2008 the curve was negative (i.e. sloping downwards) and worst case scenario, is that a negative yield curve signals potential recession as there is no premium for long term rates like you would expect. Right now, 5 August, the curve is incredible steep with current interest rates at 3% and 5 year government bonds yielding around 5.5%. This curve indicates there is only one direction for rates to go and that is up...and that is only likely to occur if the economy is strong.

There is no doubt the outlook for the Australian economy and global economy) has improved in recent months, but the speed of the improvement, whether sharemarkets or the strengthening of the above yield curve, has been startling. Whilst yields aren't what they used to be, has this rapid improvement been to fast, so is there a short term opportunity for bonds? If not, then can this yield curve get steeper?

Apples and Oranges of Volatility

My latest IFA educational article can be found here.

Recently I met with a fund manager who was showing me how his direct property fund had lower volatility than the listed property index. Given the infrequency of direct property valuation, volatility measures, like standard deviation, should probably be ignored.

My latest article published in IFA magazine simply shows how volatility can be manipulated and mis-used...just like my friendly direct property fund manager.

Alpha does not equal Outperformance

An article I wrote earlier in the year for IFA magazine can now be found here. Basically the article shows how it is possible to outperform and index but display no skill (or alpha); and vice versa...i.e. underperform an index and show skill (or alpha).